The present invention is related to event-linked protection products and structures, and credit-linked protection products and structures.
Event-linked protection products and structures, such as insurance, indemnify an entity or a person for loss resulting from fortuitous, identifiable, insurable events. Credit-linked protection products and structures are transaction structures designed to protect a party from loss as a result of its exposure to another party's credit.
As noted, event-linked protection products and structures include insurance. For example, homeowner's insurance can protect a homeowner from losses due to perils such as fires, hurricanes, earthquakes, floods, etc. Health insurance can protect an individual against financial losses occurring because of health issues. Life insurance allows a policyholder to protect his or her designated beneficiary(ies) in the case of the insured's death.
There are, of course, many other types of insurance and reinsurance. One type of reinsurance is a government-administered catastrophe funds. FIG. 1 is a diagram of how such a government-administered catastrophe fund may operate, in this case, the Florida Hurricane Catastrophe Fund (FHCF). As shown in FIG. 1, the Participating Insurer issues a number of residential insurance policies to residential property owners, for which the property owners pay their insurance premiums to the Participating Insurer. The government-administered catastrophe fund, in this case, the FHCF, agrees to reimburse the Participating Insurer in exchange for premiums paid by the Participating Insurer to the fund. In the case of the FHCF, the premiums are actuarially determined based on the exposure profiles of the participating insurance policies with the homeowners. Both the retention amount and the maximum coverage limit for the reimbursement provided by the FHCF are proportionally related to the premiums.
If the cash balance in the fund is insufficient to pay the claims arising from a hurricane, the FHCF is authorized to raise funds for the reimbursement payments by issuing revenue bonds. To cover the debt service on the issued revenue bonds, the FHCF is authorized to impose an emergency assessment on most property and casualty insurance revenues in the state. Debt service on the revenue bonds is also covered through yearly reimbursement premiums collected from the Participating Insurers.
Credit-linked products and structures protect an entity or person (the Protection Buyer) from the credit exposure the entity may have to a third party (the Reference Entity). Credit protection can come in many forms, but certain forms of credit protection are generally not regarded, legally or for accounting purposes, as insurance. One such form of credit protection that is not considered insurance is a credit default swap (CDS). A CDS is a bilateral derivative contract under which two counterparties agree to isolate and separately trade the credit risk of at least one third-party Reference Entity, typically in connection with an identified traded obligation of such entity (the Reference Obligation). Under a CDS, a Protection Buyer pays a periodic fee to a Protection Seller in exchange for a contingent payment by the Protection Seller upon a defined event happening in connection with the Reference Obligation. When a credit event is triggered, the Protection Seller makes the contingent payment to the Protection Buyer and either takes delivery of the Reference Obligation or sets off against its payment an agreed value for the Reference Obligation. Unlike insurance, there is no requirement in the CDS market for the counterparties to actually hold the Reference Obligation at the time that the credit event occurs.
Certain types of credit-linked protection are considered insurance for legal and accounting purposes. One such type of credit protection is a surety bond. Surety bonds are trilateral contracts in which one party, the Surety, agrees to uphold—for the benefit of the second party, the Obligee—the contractual promises (obligations) made by the third party, the Principal, if the principal fails to uphold its promises to the Obligee. Such contracts are typically formed so as to induce the Obligee to contract with the Principal, i.e., to demonstrate the credibility of the Principal and guarantee performance and completion per the terms of the agreement.
Another type of credit-linked protection that is considered insurance is a financial guarantee. In a financial guarantee, the insurer agrees to indemnify a party against loss resulting from a third party's default under specifically identified loans or other obligations.
Another type of credit-linked protection that is not considered insurance is a letter of credit. In a letter of credit, a party (the Applicant) arranges for the writer or issuer, typically a bank, to issue a letter of credit to a beneficiary, under which the writer or issuer agrees to make payment to the beneficiary, either on a conditional or unconditional basis, upon demand.
As noted above, CDS is not considered insurance for legal and accounting purposes. Surety bonds and financial guarantee policies are considered insurance, but in both types of arrangements, the insurer has recourse to the party whose credit is subject to protection (the Principal in the case of a surety bond, and the debtor in the case of a financial guarantee) for repayment of the amounts paid to the obligee or insured. Similarly, in a letter of credit, the writer or issuer has recourse to the Applicant (or another third party such as a guarantor) through a reimbursement arrangement which is triggered upon draw down by the beneficiary.
Event-linked protection, usually in the form of insurance, has historically been considered distinct from credit-linked protection, usually transacted in the capital markets. The inventor has created a product that combines features of both of these products and market segments into a single product.
Until the present invention, the inventor was not aware of any event-linked credit protection product, especially one that qualified as insurance for legal, regulatory, and accounting purposes (or as reinsurance if the party obtaining the product is an insurance provider), which (a) makes an indemnity payment for actual loss incurred following both an insurable, fortuitous peril (such as a hurricane) and a credit event (such as the failure to pay on an obligation); and (b) does not involve recourse or reimbursement from the party whose credit is subject to protection, or a guarantor. For example, currently an entity can buy insurance that protects against losses resulting from an insured-against event, but there is no known product that allows an entity to buy protection that a particular third party will experience a credit event in conjunction with the insured-against event. Similarly, an entity can buy, through the CDS markets, protection against a credit event involving a Reference Party and Reference Obligation, but this type of derivative product does not protect against the credit event occurring because of a particular insurable event such a hurricane, tornado, fire or other fortuitous, insurable peril.